Investor: An insider's guide to the market: Bank stocks have been an active feature of stock market trading across most stock exchanges in the first weeks of 2004.

A combination of the generally attractive dividend yields on offer and favourable expected profit growth rates - due to the improving global economic environment - have drawn investors to banking issues.

The potential for merger and acquisition activity is another factor exciting investors' interest in the sector, and the latest $58 billion (€47.66 billion) mega-merger in the US involving JP Morgan and Banc One has only served to stimulate additional interest in the sector. In a rising market, European banks have more than held their own so far in 2004, with the FTSE E300 Bank index up by 4 per cent year-to-date compared with a 3.4 per cent gain for the FTSE Eurotop 300 index.

Irish-quoted banks have out-performed the European average by a wide margin. Over the first few weeks of this year, Anglo Irish has yet again led the pack with a rise of just under 9 per cent.

However, Bank of Ireland and AIB are not far behind with share price gains of 8 per cent and 7 per cent respectively and Irish Life & Permanent follows a little further behind with a still respectable year-to-date gain of more than 6 per cent. Attractive valuations and growing optimism regarding the prospects for the Irish economy have been the key factors underpinning investor interest in the sector.

A further speculative twist was recently added to the mix with news that some of the large US banks may be seriously considering European acquisitions.

While there may be little substance to this speculation concerning the Irish banks, it has acted to focus investors' attention on the valuation attractions of the quoted Irish banks. Despite the recent share price gains, the quoted Irish banks still look very attractive on valuation grounds.

The two main banks - AIB and Bank of Ireland - are now almost exactly the same size as measured by market capitalisation and both trade on an almost identical price-earnings ratio (PER) of about 10.5. AIB's dividend yield of 4 per cent is higher, although Bank of Ireland still offers an attractive yield of 3.2 per cent. Anglo Irish Bank and Irish Life & Permanent are valued on somewhat higher PERs of around 13.5.

Irish Life & Permanent's yield is relatively high at 3.7 per cent in contrast to Anglo Irish Bank's yield of just 1.4 per cent.

This low dividend yield reflects the fact that Anglo has been retaining a high proportion of earnings in order to fund its very rapid expansion in recent years.

As long as it can maintain this strong growth momentum, its low dividend yield is unlikely to limit its share price performance.

The takeover of First Active by Royal Bank of Scotland (RBS) - owner of Ulster Bank - has also undoubtedly had a positive effect on sentiment towards Irish financials. RBS paid a significant premium to gain control of First Active thus serving to highlight the inherent investment value available in the Irish banking sector.

While further merger and acquisition activity is a possibility, the sector is not dependent on such activity to deliver value to shareholders. Developments in the Irish economy and in interest rates hold the key to the performance prospects for these stocks.

The Irish economy has proved to be very resilient throughout the global downturn and could well surprise with a strong recovery this year. Above-par Irish economic growth would have an immediate positive impact on banking profits. Interest rates are at historical lows and most commentators now expect them to rise sometime in 2004.

A sharp rise in rates would be unwelcome news for the banks, as it would increase the incidence of bad debts. But a modest rise, which is all that is expected, would probably be beneficial as it may enable the banks to widen their profit margins.

Accelerating economic growth and a gently rising trend in interest rates is close to an ideal environment for banks.

If this scenario, or one close to it, unfolds in the Irish economy in 2004, then the early positive trend in Irish financial stocks evident in recent weeks could well have much further to run during the course of this year.